The 2013 Nobel Prize for economics celebrates that financial markets work, but cautions how little we know. One theme unifies the work of all three winners: Eugene Fama, Robert Shiller and Lars Hansenórisk. (A disclosure: until August I worked at Dimensional Fund Advisors, where Fama is a director and consultant.) Risk is unpredictable, but can be very profitable. That sounds simple enough, but it has profound implicationsónot only for the lords of high finance, but households, too. Risk teaches humility, to overconfident investors and also policymakers. That humility was absent at IMF/World Bank meetings last week. Policymakers should take special note of the prize this year; it reveals how little we really understand about financial markets.
Famaís work showed that prices incorporate all available information; this is known as the efficient market hypothesis. The implication is that you cannot systematically outperform the market, unless you have information other people donít or can access part of the market others canít. But that doesnít mean you canít make money. Over time you can expect, but are not guaranteed, that riskier assets generate higher returns. Stocks, on average, return more than bonds because they are riskier. The stock of smaller companies is riskier than larger ones, so they typically generate more returns. Itís a straightforward concept, but often poorly understood. Even many sophisticated investors get it wrong.
The implications of this theory changed markets, even for the average investor. The concept of efficient markets helped create demand for index funds. Index funds are a type of mutual fund, which is a collection of many different stocks. Active funds profess to know which stocks will outperform the market. Index funds donít make that promise; stocks are weighted by their size relative to the rest of the market or use a weighting based on identifiable price or size characteristics. Because thereís no magic formula or talent presumed in constructing these funds, they are cheap; if no one can beat the market, why pay 1-2% of your assets to someone who claims they can? If you believe in efficient markets youíd only hold index funds. This has